Bid-ask Spreads, Commissions, and Other Costs

This chapter examines trading costs associated with buying and selling securities in organized exchanges such as the New York Stock Exchange. Costs are categorized as commission charges determined by the exchange and cost components of the bid‐ask spread determined by market participants. The bid‐ask spread consists of three main components: (1) order processing costs associated with the cost of providing liquidity, (2) inventory costs due to short‐term order imbalances, and (3) adverse selection costs related to the cost of trading with informed traders. Spreads and commission charges are currently at very low levels in developed markets and have led to a great expansion in algorithm trading and trading volume. Trading costs for emerging markets are considerably higher than for the more developed markets. Market capitalization and liquidity differences explain some of the variability in trading costs in exchanges around the world. Besides firm‐specific differences, a second element of variability is attributed to differences in market structures.